Real estate and inflation

By
Ned A. Gray, Paul A. Matlack

May 18, 2011

Commodity prices have been volatile as of late — no doubt about it. Like many other types of assets, they're subject to short-term gyrations driven by factors that include investor sentiment, global political developments, and sudden disturbances in supply-and-demand relationships.

Analysts are asking a number of questions in light of today's price movements: Does the decline reflect a meaningful change in commodity fundamentals, or have prices become completely detached? Will price support come back? If so, what will be the main factors?

These questions are discussed by Ned Gray, chief investment officer for global and international value equity, and Paul Matlack, fixed income strategist.

By Ned Gray

There may not be a single black-and-white answer to recent volatility in commodities, but going forward one thing seems certain: Prospects for commodity pricing depend critically on basic supply and demand. It is useful, therefore, to look at each side individually. Although sustainable levels of demand growth — coupled with enduring constraints on the expansion of supply — will support relatively strong pricing in the long term, cyclical drivers also remain in place, and are likely to increase in significance as pricing accelerates. Dramatic short- to medium-term swings in price are therefore likely to remain, in my view, a fact of life.

Demand: Two sides of a coin

When it comes to fundamental demand for commodities, China's apparently insatiable demand for an array of commodities has received headline coverage for some time, but it is only the most obvious among many rapidly growing emerging markets. Several factors have contributed to the magnitude of the demand increase in a relatively short time, with the high absolute level of GDP growth being only one. Other major factors at work include:

Increasing intensity of commodity consumption as a share of the total economy. As economies develop and industrialize, the consumption of many commodities per capita increases significantly more rapidly than the economy overall.

Increasing reliance on seaborne trade in commodities. While overall demand growth in places like China has been very strong, its impact on global markets has been greatly magnified by having a rapidly increasing share of that demand met from overseas markets, where pricing is set. As China has shifted from being a minor player in global commodity markets to a major net importer, new demand as a percent of available capacity has increased dramatically, straining the supply side and pushing prices higher.

At the same time, speculative demand for commodities is also at play. Though the magnitude of this source shifts over time and is hard to pin down, it is likely to remain a critical contributor to commodity pricing. By their very nature, the scale and volatility of commodity markets attracts speculative interest, and the interaction of speculative and underlying fundamental demand often exaggerates price movements.

Brief examples of how the interplay may unfold are as follows:

Speculative purchases by industrial buyers generally occur under conditions of rising prices, as those purchasers strive to keep their average cost down by building stockpiles ahead of need. This buying, of course, contributes to still further price increases.

Financial speculation by non-industrial buyers increases as traders seek to capitalize on price movements, increasing the preponderance of long positions as prices rise.

Because these speculative purchases tend to move concurrently, and because investor appetite for further exposure eventually becomes exhausted, they tend to contribute to patterns of accelerating price appreciation followed by steep declines.

Supply: A look at three commodity sectors

Mining/Industrial Metals

Unlike other industrial sectors, the investment cycle in mining is years or even decades in length. The process required for the exploration, verification, permitting, development, exploitation, and transportation of a new source of supply does not change by much (if at all) in the short term and imposes high hurdle rates of company returns to be considered at all. Even within existing productive properties, the rate of production is generally determined by the underlying geology and not subject to significant change in the short term. Sure, significant increases in capital expenditures by mining companies can lead to strong production growth, but such growth nearly always plays out in the longer term. Capacity constraints among equipment suppliers has further limited the growth of production and helped to support strong pricing. Though growth in supply is likely to reach a more stable equilibrium with demand in the long term, we believe the constraint on that expansion has been and is likely to continue to be a major structural support for secular strength in commodity pricing.

Energy

Though the existence of major swing producers such as Saudi Arabia (in oil) and Russia (in natural gas) creates a different dynamic than that seen in metals, overall the upward shift in global demand has put strains on the industry's ability to replace depleting resources with new reserves. Since this spring, political concerns surrounding regimes in North Africa and the Middle East have lent support to energy pricing, though actual supply disruption has been limited. While reserve depletion remains an ongoing issue in the oil sector, the highly fragmented and broadly distributed array of supply sources for crude suggest that a reasonable balance between demand and supply could be maintained.

Agricultural

Though short-term swings in grain prices should remain a function of weather-related supply volatility, secular drivers are also likely to remain significant. Higher standards of living in developing economies may place demands on the productive capacity of the world's regions under cultivation for the foreseeable future. With limited availability of unused arable land, production growth will largely have to come from higher productivity. This trend should provide support for nonfood agricultural commodities such as fertilizer. Though the supply outlook for grains might depend on the rate and pattern of global productivity gains, the uneven distribution of arable land suggests that an increasing percentage of the world's production will be traded and shipped over long distances. Under this scenario, an increasing portion of grain production would be priced on global rather than local markets, with a significant benefit accruing to those growing regions with the highest efficiency and the most favorable unit costs.

By Paul Matlack

Point of view: Commodities

Commodity prices have been volatile in recent sessions, raising concerns about the possibility of a steep downslide. Is the situation as precarious as the financial press suggests? "We may see less support for prices in the short term," says fixed income strategist Paul Matlack, "but I don't think we're witnessing a bubble bursting." Several key points are considered in discussing the general outlook for commodity prices:

1. Commodities markets have at least two dimensions.

Commodities are as much financial instruments as physical goods. As such, they respond to financial as well as physical supply and demand.

2. Commodities prices can be agitated by speculative buying and selling.

Since many commodities are transacted in dollars, dollar strength (and weakness) can influence prices, often in a vicious or virtuous cycle.

4. Emerging-market economies should be a source of demand.1

Demand from China, particularly for industrial metals, has persisted generally speaking, it should support higher commodity prices.

5. Recent price weakness is a combination of several factors.

Prices softened as a result of pressure from profit taking; relative strengthening in the dollar; indications of slow-growth recoveries in the U.S. and Europe; and a general sense that tension in the Middle East has not apparently resulted in significant supply shortages (particularly in oil-rich states).

The views expressed were current as of May 18, 2011 and are subject to change at any time.

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Ned A. Gray biography

Ned A. Gray, CFA

Ned Gray manages the Global and International Value Equity strategies and has worked with the investment team for more than 20 years. Prior to joining Delaware Investments in June 2005 in his current position, Gray worked with the team as a portfolio manager at Arborway Capital and Thomas Weisel Partners. At ValueQuest/TA, which he joined in 1987, Gray was a senior investment professional with responsibilities for portfolio management, security analysis, quantitative research, performance analysis, global research, back office/investment information systems integration, trading, and client and consultant relations. Prior to ValueQuest, he was a research analyst at the Center for Competitive Analysis. Gray received his bachelor’s degree in history from Reed College and a master of arts in law and diplomacy, in international economics, business and law from Tufts University’s Fletcher School of Law and Diplomacy.

Paul A. Matlack biography

Paul A. Matlack, CFA

Paul A. Matlack is a strategist and senior portfolio manager for the firm’s fixed income team. Matlack rejoined the firm in May 2010. During his previous time at Delaware Investments, from September 1989 to October 2000, he was senior credit analyst, senior portfolio manager, and left the firm as co-head of the high yield group. Most recently, he worked at Chartwell Investment Partners from September 2003 to April 2010 as senior portfolio manager in fixed income, where he managed core, core plus, and high yield strategies. Prior to that, Matlack held senior roles at Turner Investment Partners, PNC Bank, and Mellon Bank. He earned a bachelor’s degree in international relations from the University of Pennsylvania and an MBA with a concentration in finance from George Washington University.

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